Is the value added tax a useful macroeconomic stabilization instrument?

Abstract

The value added tax (VAT) has been proposed as a macroeconomic stabilization instrument. This paper considers some practical implications of a variable VAT rate. It then develops a dynamic general equilibrium model to assess its usefulness as a stabilization instrument. A variable rate VAT would no longer be less distortionary than other taxes. It would distort between current and future consumption, i.e. savings and investment decisions, and hence raise the economic costs of taxation. Moreover, a variable VAT rate would be less effective in dampening business cycles than the conventional stabilization tool, an interest rate. This is because of additional adverse supply effects. A change in the interest rate affects this period's savings and investment decisions, whereas a variable VAT rate would influence savings and investment decisions over time. A variable VAT rate is therefore unlikely to be a useful stabilization instrument.